Webinar review: Are you ready for the margining of uncleared swaps?

Buy-Side FeaturesRegulationWebinars
17 Dec, 2015

DTCC, the sponsors of the webinar, will publish a white paper, The Impact of Margin Requirements for Non-Cleared OTC Derivatives on the Fund Management Industry, shortly. It includes full details of the survey conducted by COO Connect on behalf of DTCC. To secure your copy of the white paper, please register your interest here.

New rules on the margining of non-cleared OTC derivatives contracts start coming into force on 1 September 2016. These rules, which have yet to be completely finalised in either Europe or the United States, will impose additional costs, systems investments and operational complexities on fund managers that use OTC derivatives. To assess the readiness of the fund management industry, and identify the issues of greatest concern, Dominic Hobson, founder of COO Connect, invited Paul Quarto, director of product management and professional services, collateral management group, DTCC, Jaki Walsh, managing director, Derivati Consulting, and Will Winterton, senior associate, Clifford Chance, to join him at a webinar for members of COOConnect. This is an edited version of the discussion.

New rules on the margining of non-cleared OTC derivatives come into effect next year. In fact, the timetable for implementation set by the Basel Committee on Banking Supervision (BCBS) and the International Organisation of Securities Commissions (IOSCO) is aggressive. For the largest market participants, initial margin will have to be posted from 1 September 2016 and variation margin from 1 March 2017. Yet fund managers preparing to meet these deadlines must cope with the fact that the regulations governing the margining of non-cleared derivatives have yet to be finalised in any major jurisdiction.

The only regulators to have issued final rules are the Prudential Regulators[1] in the United States. Fund managers regulated by the Commodity Futures Trading Commission (CFTC) have yet to take delivery of definitive guidance. The European regulators[2] have so far reached the stage of issuing a second consultation paper only. Given the lack of final sets of rules, less than nine months ahead of the start date, the period between the finalisation of the rules and their implementation is inevitably going to be short.

It is therefore helpful that the draft rules are broadly the same on both sides of the Atlantic. The majority of asset classes - interest rates, FX, equity, commodities and credit - are captured in both Europe and the United States. The main differences are that physically settled FX swaps and equity options and forwards are in the scope of the European rules for variation margin only, but out of scope of the American rules altogether. This does create scope for bifurcation of the market as fund managers look to take advantage of the jurisdiction where margin rules do not apply, or are less onerous.

But when it comes to transacting business day-to-day, differences both major and minor between regulatory jurisdictions are likely to be problematic rather than beneficial, in the sense that the rules may conflict. Both American and European regulators have contemplated permitting compliance with one regime to count in the other – what is known in Europe as “equivalence” and in the United States as “substituted compliance” – but nothing is yet finalised. It is not known how or when the regulators can be expected to make meaningful progress on this issue.

Fortunately, regulatory conflict is a problem fund managers active in both Europe and the United States have experienced already. The Dodd Frank Act and the European Market Infrastructure Regulation (EMIR) created differences on the cleared side of the OTC derivatives industry, so global managers have already proved that they have the capacity to absorb conflicting rules. Other managers have chosen to avoid any potential regulatory conflicts on cleared business by restricting their activity to a single jurisdiction, and will likely do the same for non-cleared transactions. Avoiding jurisdictions will not be as straightforward in the case of non-cleared transactions.

Some managers will escape the need to comply at all. However, buy-side firms of all kinds doing bi-lateral OTC derivative business with a broker-dealer - whether they manage alternatives, mutual funds, pension funds, or insurance company assets - are in theory caught by the rules. But in practice few are expected to have to comply. At €3 trillion or $3 trillion in gross notional amount of non-cleared OTC derivatives at a group-wide level, the initial threshold for compliance from September 2016 is relatively high. All but the largest fund managers are likely to fall outside the rules.

Even for those that are caught, the only significant change is the requirement to post initial margin. Although the new variation margin rules are stricter than current bi-lateral practices, it is extremely unlikely that any fund manager using swaps is not already exchanging variation margin with sell-side counterparties in bi-lateral OTC derivative contacts. And although the qualification threshold for initial margin reduces over the four years down to September 2020 from $3 trillion or €3 trillion to just $8 billion or €8 billion, fund managers will continue to benefit from the fact – unlike other market participants - that the gross notional amount will be calculated not at the group level but on a fund by fund basis.

The ultimate threshold of $8 billion or €8 billion is the same as the one the regulators set for capturing managers in cleared OTC derivative business. However, the initial margin calculation is less generous, with the aim of driving more OTC derivative business into a cleared environment. Any manager below the $8 billion or €8 billion threshold will know already that they are not caught by the non-cleared rules. This is a further reason to expect that relatively few managers will have to comply with the new rules on initial margin, in either September 2016 or later.

That said, managers will of course be affected by the stricter rules on variation margin. They will also be affected indirectly by the new rules on margining of non-cleared derivatives, because their sell-side counterparties will adjust their prices to take account of the new margining rules. However, the cost and administrative burden of compliance will fall mainly on the clients of the fund managers: the large pension, insurance and sovereign wealth funds. They cannot measure themselves against the thresholds on a fund by fund basis.

For those funds caught by the rules, the new environment will be unfamiliar in one important sense. This is that collateral will have to be posted as initial margin, not on a title transfer basis to a counterparty, but on a security interest basis to an independent third party custodian bank. The custodian has no right to re-hypothecate the collateral under the regulatory regimes of either the United States or the European Union. Cash can be posted in either jurisdiction, creating a counterparty credit risk against the custodian, which in the United States at least is managed by a requirement to reinvest it promptly in eligible securities.

Managers posting initial margin voluntarily are not obliged to use a third party custodian until they pass the $8 billion or €8 billion threshold. However, managers above the threshold will have to meet the additional cost of paying a third party custodian to hold and move collateral on their behalf, in much the same way that they have to meet the additional cost of clearing OTC derivatives through a central counterparty clearing house (CCP).

Although many managers have already opened separate accounts with their custodians to hold collateral, there will almost certainly be additional costs. This is because the volume of movements will increase, and the custodians cannot profit from re-hypothecating the assets. Managers will incur legal fees too, since documentation will have to be re-written to take account of the switch from a title transfer to a security interest regime.

This work cannot begin until the rules are finalised, and large managers are likely to have more than 1,000 credit support annexes (CSAs) in place. The work will not be trivial for any manager obliged to post initial margin, in terms of volume, let alone complexity, and it is therefore prudent for every manager to digitise their CSAs immediately. For variation margin, the challenge is less severe. The International Swaps and Derivatives Association (ISDA) is expected to publish a simple protocol, which  will suit all but those managers which decide they wish to make bespoke arrangements with counterparties.

If and when they do come to re-write their documentation, managers will find the range of collateral eligible for posting is relatively wide. The range of acceptable collateral has already narrowed, even with the bi-lateral markets. So the fact that the rules allow counterparties to post cash, government securities, corporate debt, equities and gold in Europe (for both variation and initial margin) and in the United States (for initial margin only) is, on the face of it, generous.

However, the CFTC allows cash collateral only for variation margin, and the cash has to be denominat­ed in either US dollars or the payment currency of the underlying derivative trade. There are also restrictions in Europe as well as the United States on the use as collateral of securities issued by the same organisation as the poster (assets with so-called "one-way risk"). For the same reason, inter-dealer swaps in the United States cannot be collateralised with securities issued by banks.

In Europe, concentration limits are set. The most important limit prevents systemically important financial institutions from accumulating an exposure to any one sovereign issuer greater than 50 per cent of at least €1 billion in assets under management. Bi-lateral CSAs agreed between fund managers and investment banks have long favoured sovereign bonds and cash, and most managers tend naturally to invest heavily in their domestic government bond markets. Investment mandates also tend to insist that exposures be collateralised entirely with sovereign bonds. As a consequence, a 50 per cent ceiling might be problematic for some larger managers.

€1 billion is not a high a number for a single proprietary fund, but few fund managers are deemed to be systemically important. This means the 50 per cent concentration limit on sovereign debt will not affect the vast majority. However, it will affect large numbers of their clients, on whose behalf they might send and receive margin, and be mandated to accept nothing but sovereign debt. So managers will need to invest in a system to monitor the 50 per cent limit on behalf of their clients. Fortunately, there are a number of appropriate systems available from vendors. In addition, non-sovereign securities, and securities issued by banks and investment firms, are subject to separate concentration limits of 10 per cent and 40 per cent respectively, and these do apply to fund managers as well.

Scheduled haircuts apply under the rules in both Europe and the United States, but the only significant departure from current practice is an additional haircut of 8 per cent if a derivative position is collateralised with securities denominated in a currency different from that of the underlying exposure. FX trades are unaffected, in that they are always margined in the settlement (or “transfer”) currency, but it will be difficult for any manager with a multi-currency portfolio to avoid running into the 8 per cent additional haircut, especially those who buy and sell assets denominated in more exotic currencies.

Having to execute a foreign exchange trade in order to obtain assets of the same currency will entail significant transaction costs. Avoiding the additional haircuts for cross-currency collateralisation is also likely to pose operational and systems challenges for fund managers. Fortunately, under the European rules, the 8 per cent additional haircut will almost certainly apply to non-cash collateral posted as initial margin only – variation margin, being payable in cash, is not subject to the additional haircut - and most managers will own more than enough securities to comply without difficulty. [3]

However awkward the new rules prove to be, and however helpful preparations for the clearing of OTC derivatives have been, the level of readiness among managers for margining of non-cleared derivatives is low. A poll of 89 fund managers in both Europe and the United States, conducted in October and November 2015 by COO Connect on behalf of DTCC, found only 14 per cent were confident that they were ready to cope with the new rules. Yet the new rules represent a potentially significant increase in both the speed (like the cleared market, the non-cleared market is moving to intra-day margin calls) and volume (since both fund managers and their counterparts will be exchanging initial margin for the first time) of margin calls, and their complexity (in terms of margin calculation).

The survey results is understandable, in the sense that managers are reluctant to prepare for a regime whose rules have yet to be finalised. But it is also worrisome, since many fund managers have not previously posted initial margin, as opposed to variation margin, against their OTC derivative contracts. In addition, those planning to use a vendor system to automate margin call management, or to outsource the task, will have less time to meet the implementation timetable than managers handling the problem in-house.

They will also have less time to meet margin calls intra-day, especially if they are reliant on a third party collateral manager, most of which currently work to a trade date plus one day (T+1) timetable at best, and might easily need two days to move and report collateral, or substitute it when a fund wants to sell the collateral. Yet the survey found a third of managers polled are planning to use a vendor system, and a further 16 per cent intend to outsource to a third party collateral manager. Worse, nearly a quarter of poll respondents are presently managing margin calls manually.

The difficulty of coping with an increase in volume - especially for firms managing margin calls manually - will be increased by the multiplication of margin calculation methodologies. The regulatory regimes allow managers to use either a standardised margin schedule they have published or use an internal or third party risk-based margin model. In an effort to help standardise margin methodologies, ISDA has developed a standard initial margin model (SIMM) for users of non-cleared derivatives and vendors of derivative valuation services. It uses risk weights and correlation tables to specify the initial margin requirement as a percentage of the gross notional amount of the exposure in each asset class.

The poll also found only one respondent in ten was entirely confident of their ability to calculate initial margin using the standardised model and even fewer (just 5 per cent) of their ability to calculate initial margin using a risk-based model. Inevitably, as they do today, managers will come to rely on risk-based calculation engines supplied by vendors (such as Bloomberg, Markit and Super Derivatives) and approved by the regulators. This is because margin calls have to be agreed with counterparties, and it minimises margin call disputes if both parties use the same methodology. Not many managers will use in-house models. Nor is the market likely to settle on a single model.

The calculation of gross notional exposure is likely to be more problematic. Every sizeable institutional fund uses more than one fund manager, and no one manager is privy to the derivative positions accumulated on behalf of the same client by another manager. Managers will have to rely on their clients - or their custodian bank, if it services the entire group - to report their overall gross notional positions accurately. This helps to explain the relatively low level of confidence among poll respondents in their ability to calculate gross notional exposures at the group level. Only 9 per cent felt they could meet the challenge today.

Another major challenge for fund managers is the need to raise cash. This is the only collateral eligible to meet variation margin calls in the United States, and the least complicated asset to deliver as initial margin both there and in Europe. The poll found one respondent in three was confident of their ability to obtain cash collateral, and a further 53 per cent “somewhat” confident that they could, so levels of readiness to obtain and post cash collateral are not high. Accordingly, it will help that the European regime is more willing to accommodate securities instead of cash in both variation and initial margin calls.

The need to raise cash in the repo market, or hold cash routinely as part of an investment portfolio, is the most obvious of the extra costs managers will face as a result of the introduction of the new rules on the margining of non-cleared OTC derivatives. They will also have to invest in legal advice, monitoring systems, margin and exposure calculation methodologies, and third party custody and collateral management arrangements. Without robust systems and procedures to manage their OTC derivative business across cleared, non-cleared and legacy portfolios, managers face the risk of making serious and continuous operational errors. They are best advised to start addressing the challenges of the new environment immediately.


DTCC, the sponsors of the webinar, will publish a white paper, The Impact of Margin Requirements for Non-Cleared OTC Derivatives on the Fund Management Industry, shortly. It includes full details of the survey conducted by COO Connect on behalf of DTCC. To secure your copy of the white paper, please register your interest here.

You can watch and listen to a full re-run of the session here:

And you can download a copy of the slides form the webinar here

For further information or advice on any of the issues raised in this edited version of the webinar discussion, please contact:


Paul Quarto

Director of product management and professional services, collateral management group





Jaki Walsh

Managing director

Derivati Consulting




Will Winterton

Senior associate

Clifford Chance


[1] Office of the Comptroller of the Currency, Treasury (OCC), Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation (FDIC), Farm Credit Administration (FCA) and Federal Housing Finance Agency (FHFA)

[2] The European Securities and Markets Authority (ESMA), the European Banking Authority (EBA), and the European Insurance and Occupational Pensions Authority.

[3] The explanatory text published in the second consultation paper from ESMA, the EBA and EIOPA on 10 June 2015 reads as follows: As cash for VM is considered the pure settlement of a claim, this should not be subject to any haircut. Furthermore, VM and IM should be considered separately when identifying the reference currency for this purpose: the transfer currency is the most natural choice for the VM, the termination currency the most natural for IM. Where “transfer currency” and “termination currency” do not appear in a bilateral agreement, the FX haircut should apply to the entire collected collateral. Where the agreement between the two counterparties includes a termination currency, the counterparties shall apply a haircut of 8% to the market value of the assets where the collateral posted as initial margin is denominated in a currency other than the termination currency. Where the agreement does not identify a termination currency, the haircut will apply to the market value of all the assets posted as collateral for initial margin.” See  European Securities and Markets Authority (ESMA), European Banking Authority (EBA), European Insurance and Occupational Pensions Authority (EIOPA), Second Consultation Paper,  Draft Regulatory Technical Standards on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP under Article 11(15) of Regulation (EU) No 648/2012, 10 June 2015.